Sunday, February 19, 2006

(P.S: Sorry for any disturbances the advertisements above may have caused you)

Main issues

1.High valuation based on ex-extraordinary item profits

2.Rising interest rates

3.Investment properties revaluation could be a double-edged sword

4.China regulatory risk

It was rather interesting that for my last pick of Hong Leong Asia there appeared to be mass consensus that I was wrong: 5 out of 5 voters thought I was wrong, in the online poll conducted. Well, believe the next one might prove rather controversial as well, given all the optimism on the property recovery nowadays.

I know I have said before that GLCs are some of the best investment stocks to go into because their strong government links often lead to plum projects with fat margins but sometimes valuations overstretch in the face of investor exuberance.

The company announced a record set of earnings on Thursday but one might note that about two-third of that was due to extraordinary gains mainly from the sales of its stake in Raffles Holdings (S$750M out of $1.15B, before minorities). If one were to consider the operating profit after tax for the past two years, it appears that it fluctuates around S$400M. As asset disposals rob it of further recurring earnings, this figure is likely to remain stagnant in the foreseeable future. If we consider ex-extraordinary after-tax profit attributable to shareholders, it is about S$300M --or ~S$0.12 per share. What this means is that ex-extraordinary items, Capitaland is now trading at ~34X FY05 PE.

Capitaland comprises a residential property arm, a commercial property arm, a retail property arm, a service residences arm (Ascott), and a finance services/asset management arm (for REITs). Its commercial/retail/service residences segments typically contribute revenue by means of rents collected, which is recurring and more predictable. Residential property developments are typically patchy and project-based, and this of course adds a dimension of risk if the market should take a downturn. Note that the residential property segment contributes >50% of operational profit, and has declined year-on-year despite a strong top-end property market which Capitaland is apparently well-positioned in.

There are many ways to look at this company, and it is not an easy one to dissect, given its multi-focal, multi-local operations -- in different functional segments, in multiple markets. One can say that it is a leading proxy play on the property market of rising Asia, a play on the Singapore property reflation market, a company well-positioned to thrive on the late-stage business cycle when recovery of consumer demand extends to large-budget items ie. property. In the light of its more than 2X price surge to its $4/share price tag now, I choose to highlight the other side: the primary problem of rising interest rates. Firstly, rising rates is the primary enemy of property developers because it saps consumer demand and confidence; however there are other company-specific problems with rising rates. It reduces attractiveness of REITs as an asset class, hence it may grow more difficult to package off the company's properties and recycle capital --- this asset-light strategy has been a key to Capitaland's growth the last 2-3 years. Thirdly, Capitaland's interest payments are likely to become a greater burden -- the group's short-term and long-term debt currently amount to S$6.5B (vs equity of $9B), requiring debt service of S$300M or ~40% of operational profit. Even the securing of the IR at Marina may not be such a great piece of news --- besides the fact that several top bidders pulling out hints of lower-than-anticipated profitability of the project, an IR development costing $4-5B would probably require the company to take up another huge loan.

The fact that the company diversifies its operations in various Asian countries, primarily Singapore but also in Australia, China, Hong Kong, Thailand mitigates any geographical risk, but does not eliminate it completely. Government measures typically play a big role in property by influencing public consumption patterns, and more than most other sectors, these have a significant impact on property developers by virtue of their heavy sunk capital. Look at how income from China slumped from $90M in 4Q04 to $25M in 4Q05, a result of the Chinese central government's macroeconomic cooling measures to counter a growing asset bubble. Furthermore, one might also note that a substantial item on Capitaland's balance sheet is its S$6B Investment Properties portfolio, where revaluation is being performed regularly. Profits could easily turn on a dime if economic conditions should change abruptly (as it did during 1997) and cause writedowns on properties to be effected.

In spite of all these risks, my case still rests primarily on valuation. PE is probably less important for property companies compared to net asset value, and here there is a relevant measure known as RNAV - Recalculated Net Asset Value: the sum of market values of all investment properties and associates (at listed market capitalisation), plus estimated net present value of development properties, plus unlisted arms at appropriate PEs -- see CIMB-GK Goh's recent report for a sample. It would be impossible to calculate it myself --- I defer to the brokers in this case, and indeed 3 different brokers have remarkably close estimates of Capitaland's RNAV: S$3.82/share for OCBC Securities, S$3.57/share for DBS Vickers, S$3.77/share for GK Goh --- all below the current $4.10. What differs is the premium they apply to the RNAV: DBS and GK Goh both apply 20% hence facilitating high target prices (DBS also introduces a further $0.30 IR premium), while OCBC (my favourite --- they usually are quite prudent) prefers to use 5% premium only -- hence a Hold. I would just base my hot-stock-not call on the basis of the RNAV valuation alone --- in fact, if I were to apply any premium, it would be a negative risk premium, in view of the interest rate risk, an "over-optimism risk" in view of potential risk factors like interest rates and unexpected downturns described above, and lastly a possible share overhang due to Temasek's continued disposal (believe there was a placement late last year already).